Risk-Weighting of MBS and Sovereign Debt Under Financial Regulations

On Saturday, Peter Wallison of the American Enterprise Institute wrote an op-ed in the Wall Street Journal about regulators’ role in the financial crisis of 2008 and the present sovereign debt crisis. I certainly don’t agree with everything that he said, but he makes a very good point about assets that are deemed to be low-risk or risk-free under Basel or other frameworks:

First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.

Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.

Today’s European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.

In hindsight, it is obvious that Basel III should not have assigned to sovereign debt a zero risk-weighting. But even in September of 2010 (when Basel III was released), regulators should have had a solid idea that excessive sovereign debt could put a strain on the financial system. Although the severity of the crisis was not fully understood at this point, the first EU/IMF bailout of Greece occurred in April of 2010, before Basel III was introduced. Thus, regulators should have known that Greek sovereign debt carried significant credit risk.

Indeed, commentators at the time cautioned against this risk-free status. From the blog ofThe Economist, September 12, 2010:

Unless I’ve missed something, lending to AA-rated sovereigns still carries a risk-weight of zero. So one result of Basel III could be to encourage banks to increase their lending to sovereigns at the margins of zero-risk-weight status. If that happens, anyone want to guess where the next crisis will crop up?

The sad truth is that there is no set of rules that will ensure the solvency of the banking system, or its resiliency in a crisis. In a competitive market, banks have no choice but to seize any available opportunity to increase their return on capital. That means that regulators need to be dynamic in their response to changes in the marketplace, and anything that appears to generate returns with low risk should raise a red flag.

Unfortunately, the regulatory treatment of any asset category as risk-free distorts bank behavior in ways that can create a lot of systemic risk. Therefore, regulators should be reluctant to hand out the risk-free label and, if they do, they should monitor the asset class on a periodic basis. Moreover, it would be prudent to ask banks to confirm by their own analysis that an asset labeled as risk free continues to deserve that status. In other words, we should try to avoid a robotic acceptance of any asset as risk-free even as defaults become more and more likely.